The Smart Alpha Low-Volatility Select S&P 500 Portfolio went through its quarterly refresh this week, at which time five positions were closed and six new ones were established.
Five stocks were sold: YUM! Brands! ($YUM); IBM ($IBM); Dollar General ($DG); Chipotle ($CMG); and Bed Bath & Beyond ($BBBY). The only genuinely eventful one was for $CMG which, as discussed on February 4th, was hit by the ugly face of "event risk," an unpredictable and unquantifiable-in-advance development that can hit any stock. The situation at $CMG has been well publicized; it involves the food-safety problems that surfaced at this high-end quick serve restaurant chain.
The other sales were uneventful and based on the model's rules, which sometimes mean something bad happened top the company but which are often designed to close less-good positions in order to make room for better ideas that are uncovered as we go along. The latter was the basis for sales of $BBBY, $DG, $IBM, and $YUM.
As we consider these purchases, it's important to recall the goals of this strategy. I don't care what the company did in the latest quarter, nor am I interested in what guidance was. And although this may seem counter-intuitive, I'm not aiming for "value;" as discussed previously, company quality (associated with lesser volatility) is something for which we have to pay. The model seeks company's for which the fundamental business profile is consistent with the potential for below-market volatility.
Here are the six additions:
Colgate Palmolive ($CL): This is as prototypical a low-volatility stock as one might expect. The company's business, basic household products, has long been recognized as being "defensive," meaning that in bad times, it's likely to fare a lot less bad than many other businesses. (It won't avoid downturns - consumers may price shop more aggressively, currency hits are always an issue, etc.). It's a matter of degree and in this regard, the degree of volatility is low by virtue of the nature of the business. Needless to say, this is a competitive business (as if there's anything that isn't). $CL's unique handle is its particular proficiency in global markets. It was global before global became cool. Consumers around the world know it well and the company has long been expert in managing this sort of enterprise.
Church & Dwight ($CHD): This, too, is a household products company, but a much smaller one than $CL or other industry behemoths. The core of the company is its long-standing Arm & Hammer baking soda (and its association with extra cleanliness), which when added to more conventional cleaning products gives them a niche appeal. Over the years, the company has expanded its brand portfolio through acquisitions (e.g., Orajel, Trojan, Avid Health). Scale relative to industry leaders is an issue - on paper. Trailing 12 month sales for $CHD were $3.4 billion, versus $16 billion for $CL and $69.4 billion for Procter & Gamble ($PG). But with $CHD's returns on equity continuing to trend up (19.9% in the trailing 12 months versus an 18.0% five-year average, compared to industry medians of 13.8% and 11.3%) and a good balance sheet (trailing 12 month interest coverage of 22.4 versus a 12.8 industry median), the company seems to be coping quite well with its theoretical size disadvantage.
Brown Forman Corp. ($BF.B): This spirits maker is a stalwart in the most interestingly named group you may not have thought much about: BESTOGA (based on Beer, Spirits, Tobacco and Gaming). These are supposedly sin stocks (although not as much out there as firearms, adult entertainment, marijuana and the like). As with the household products group, this one is defensive based upon the small-ticket nature of these consumer purchases. But while household products deals with necessities, this group deals with desires. $BG.B's stalwart is the iconic Jack Daniels whiskey brand. It's always an interesting three-way struggle between beer, wine and spirits. Lately, though, spirits have become hip as have fancy cocktails created by "mixologists" (bartender seems so pedestrian!). But $BF.B's stability rests more on industry leadership than fashion, as indicated by trailing-12-month and five-year average returns on equity of 39.7% and 37.2% (versus industry medians of 9.7% and 15.9% respectively) and interest coverage of 26.1 versus 5.7 for the industry.
Altria ($MO): Speaking of BESTOGA, we also have the leading domestic tobacco firm and its iconic Marlboro brand. I'm not going to discuss the cigarette story here. It's well known. Let's instead focus on what role $MO might play in a low-volatility portfolio. That brings us to the A-word; addictive (if you're into social consciousness, you really have to skip this one). Although U.S. demand is in a long-term secular decline, there's still more than enough to keep $MO's profit machine pumping, and with so much consistency, it has the wherewithal to really take a meat axe to its equity capital and operate mainly with debt ($12.9 billion worth at last count, versus $2.9 million in equity). Still, its trailing-12-month interest coverage is 10.2, above the 8.2 median for the much-less-debt-heavy S&P 500 group as a whole. Forget return on equity; those numbers have been leveraged up above 100%. Let's instead consider return on assets, the variation that controls most intensely, for differences in balance sheets; $MO's figures were 15.6% and 12.8% for the trailing 12 months and past five years respectively, versus industry medians of 4.7% and 7.4% and S&P 500 medians of 4.9% and 5.3%. Obviously, event risk (regulation, litigation) always needs to be considered here. But it's not as if dramatic issues along these lines are likely to pop up anew. It's all been out there for a long time. The portfolio already got hit with $CMG and survived (hooray for diversification), as will be apparent below. I think we can live with this one as well.
H&R Block ($HRB): I have to be honest: I've always had trouble warming to $HRB, something that likely traces back many years to when my mother was a tax accountant and her firm advertised "We fix H&R Block errors." I don't know how much empirical support could have been mustered for that claim, but let's face it; it's unlikely that anybody is going to a Block storefront expecting high-level tax planning. Then again, there are many who need help with this necessary evil who can't or won't pay for a higher-level accountant and who would, or fear they would, make a mess of their returns if they use easily-available consumer tax software (I took two courses in tax law when I was in law school and got final grades above 90 in both, but even I threw up my hands with those programs and now regularly work with a human accountant). And by the way, Block has software too, and e-filing, and refund-anticipation loans. And it makes money, lots of it, enough to generate a cash flow (albeit with as much of a seasonal skew as you're likely to see) sufficiently strong to induce it to retire a big chunk of equity and replace it with debt. As future cash flows are used to nibble down those borrowings, the company's bottom line can get an added boost. Event risk is an issue here. Will Ted Cruz become President and give us his postcard-sized tax form? Who knows? I'll believe it when I see it. Meanwhile, the latest quarter was a stock-slamming dud due to a slower pace of filings due partly to more expected payments as opposed to refunds (nobody is in a hurry to pay before they must), and to anti-fraud efforts that are slowing people down. I expect Block to catch up as time passes. Still, if I were an active investor, I'd probably skip this one due to habit if nothing else. But for what it's worth, most occasions during which I tried to be smarter than my models have not fared well for me, the human. So on a wing, a prayer and lots of data, I'm in.
Varian Medical ($VAR): For me, this is the anti-H&R Block. I've loved this company for years. It, along with rival Elekta, dominates the oncology radiotherapy market, with $VAR being the leader in the U.S. Both firms are likely to benefit from increasing adoption globally, not to mention demographics and the higher incidence of cancer among aging people. And it's not just beam-and-burn. $VAR has long been known for the ability of its equipment to precisely target tumors even in hard-to-access locations and in ways that minimize collateral damage, an important consideration. There is no doubt any aspect of medical equipment can be event-prone due to shifts in the treatment landscape and in reimbursement politics. But at the end of the day, we get cancer and we want it treated and it happens to more and more people all the time. While $VAR isn't quite the rock $CL or $MO are (please, no $MO-$VAR synergy puns, eeew!), it's reasonable even for a defensive portfolio to resist being all consumer all the time. And compared to others in medical equipment, $VAR is a rock, with trailing 12-month and five-year ROE of 25.1% and 27.9% versus industry medians of, cough cough, minus 2.8% and 4.7%, and interest coverage of 67.4 versus a minus 1.2 industry median.
Figure 1 shows how the portfolio has don since it went live.
That's what I was hoping to see from a model like this. If we get a period of prolonged market strength, I expect it to underperform; that's what low-volatility models do when stocks race ahead. Speaking for myself, though, I do continue to crave low-volatility exposure. You can find out more about how the strategy was built here on Forbes.com and you can track it for free on Portfolio123.
Disclosure: I am/we are long CL, CHD, MO, BF.B, HRB, VAR.